European Central Bank Makes Major Announcement: Here’s What You Need to Know

European Central Bank chief Mario Draghi (AP)

FRANKFURT, Germany (TheBlaze/AP) — The European Central Bank (ECB) unveiled its most ambitious plan yet to halt Europe’s financial crisis on Thursday with a pledge to buy unlimited amounts of the government bonds of countries struggling to manage their debts.

Translation: The ECB may be getting into the business of funding state budgets. You know who has the most to lose from this, right? The eurozone’s most prosperous and well-0ff country: Germany.

And this isn’t just speculation. The German press is furious with the ECB’s announcement.

“ECB President Draghi breaks with brazen principles of German monetary policy. The central bank is pumping unlimited money in the bond markets. Stock markets cheer — for Germany, the nightmare begins,” read German newspaper Die Welt.

Die Welt front page (courtesy Business Insider)

If any of the ECB’s new plan sounds familiar to you, it should: It’s similar to action taken by the U.S. Federal reserve.

“In the U.S., the Federal Reserve did something similar through Operation Twist,” Chris Nichols writes for The Exchange.

“That intervention in the American bond market, involving the selling of short-term debt and the buying of the same amount of long-term debt, got underway last year and was extended only recently,” he adds.

So what’s the thinking behind the ECB’s plan?

Large-scale purchases of short-term government bonds would drive up their price and push down their interest rate, or yield, making it less expensive for countries to borrow money. The new plan goes well beyond the ECB’s earlier, limited bond-purchase program, which was not big enough to decisively lower borrowing costs.

After the ECB plan — dubbed Outright Monetary Transactions (OMT) — was announced, the yields on government bonds across Europe fell and stock markets rallied.

“The ECB did almost exactly what was expected, and in this case that’s a positive. Today’s announcement should help contain the crisis, but the weak economic outlook looms, and the ECB will need to ease policy further in the months ahead,” said Benjamin Reitzes, senior economist at BMO Capital Markets.

But the ECB’s pledge of support came with a caveat: countries that want the central bank to help with their debts must first seek emergency aid from the bailout funds managed by the 17 countries that use the euro and submit their economic policies to the scrutiny of the International Monetary Fund.

That puts enormous pressure on heavily indebted countries such as Spain and Italy, which have been reluctant to seek help from their euro partners.

The ECB also agreed to ward off any increase in the supply of money in the economy, a side effect of making purchases with newly created money. The bank said it would withdraw an equivalent amount from the financial system, which it can do by taking deposits or selling notes.

This supposedly deflects the aforementioned criticism that the ECB is using its monetary powers to finance governments, which it is forbidden to do by the European Union treaty that created the euro.

Christine Lagarde, Managing Director of the IMF, welcomed the ECB plan Thursday and said the organization stood “ready to cooperate.”

IMF chief Christine Lagarde (AP)

Analysts warned that while the ECB plan would provide short-term relief to European countries and financial markets, it doesn’t address underlying economic weakness across the region, which could persist for years.

“Without trying to be a ‘party pooper,’ suppressed borrowing costs certainly provide relief in the short term but do not resolve problems of solvency and debt unsustainability,” said Neil MacKinnon, global macro strategist at VTB Capital.

The head of Germany’s Bundesbank national central bank, Jens Weidmann, has flatly opposed the bond purchases. He says they are too close to outright financing of governments. The treaty bars the ECB from loaning directly to governments.

Nevertheless, and despite what seems like a limited amount of naysaying, investors cheered the move.

The Standard & Poor’s 500 index jumped to its highest level since January 2008, just one month into the Great Recession. European markets also surged. Treasury bond prices and the dollar dropped as traders sold low-risk investments.

The gains were extraordinarily broad; 98 percent of the stocks in the S&P 500 index rose.

The S&P 500 index jumped 26 points to 1,429 shortly after noon. The Dow Jones industrial average surged 233 points to 13,281. The Nasdaq composite index jumped 62 points to 3,131.

The Dow, S&P, & Nasdaq

European stock markets also jumped in response to Draghi’s announcement. Germany’s DAX and France’s CAC-40 each soared 3 percent.

The gains were even bigger in Spain and Italy, the two largest countries to become caught up in the region’s long-running government debt crisis. Spain’s benchmark index soared 5 percent, Italy’s 4 percent.

France's CAC & Germany's DAX

Still, it should be noted that despite the markets’ euphoria, the ECB’s “rescue” plan will only buy the eurozone time to fix its underlying problems. The purchases do not solve the chronic imbalances that plague the currency union, with some countries able to export and grow while others remain uncompetitive.

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This story has been updated. All photos courtesy the AP.